Base currency and quote currency are used in the context of foreign currency transactions, where two currencies always face each other and produce an exchange rate. What exactly is hidden behind these two terms and what they are used for is explained here.
Base currency and quote currency are two common expressions in the Forex (foreign exchange) market. So-called currency pairs are traded on this market.
Base currency (also called transaction currency) is always given first in a currency pair; quote currency (also called counter currency) is given second.
Those currency pairs that are traded the most worldwide and thus have the highest liquidity are called major currency pairs. These are:
You can see that the US dollar appears in every pairing of major currencies, because USD is the most widely traded currency in the world. Currency pairs without a US dollar, but where the two currencies are from major economies, are called minor currencies. These include, for example:
There are also exotic currencies. In these, part of a currency pair is a local currency of a smaller economy or an emerging market, e.g.:
- GBP/SGD (GBP/Singapore Dollar)
- GBP/PLN (GBP/Polish Zloty)
- GBP/HUF (GBP/Hungarian Forint)
- GBP/ZAR (GPB/South African Rand)
As already mentioned, base currency and quote currency occur when trading currencies, because a currency pair is always traded there: An investor who buys US dollars with British pounds sterling buys USD and sells GBP.
If this investor looks at the exchange rate for GBPUSD, he sees how many US dollars he can buy for a certain amount of GBP. If he knows the correlations and influences on the exchange rate, he can make estimates as to whether the exchange rate will rise or fall in the near future and manage his investment in this way.
If he expects the price to rise, he buys USD and can sell them again at a later date when the price has risen, thus making a profit.
Companies that are internationally active and also do business in foreign currencies are also interested in currency pairs. For a British company that does business in the USA in US dollars, the USD/GBP or GBP/USD currency pair is interesting.
By monitoring these currency pairs, the company can manage its investments more cost-effectively, for example by using hedging options to freeze a certain exchange rate. If the exchange rate changes to the company's disadvantage, the frozen exchange rate still applies thanks to the hedging contract, so the company does not incur a loss.
The GBP/EUR currency pair (also written as GBPEUR) describes the exchange rate between the British pound sterling and the euro. In this notation, GBP is base currency and EUR is quote currency.
If GBP/EUR = 1.15, this means that you can exchange £1 worth of GBP for 1.15€. For £100 you get 115€ at this exchange rate.
If the currency pair is EUR/GBP = 0.87, the euro is the base currency and the British pound is the quote currency. For 1€ you get £0.87.
A British company has opened a new location in the USA. It now wants to invest in its expansion there and purchase a warehouse. The warehouse currently costs $100,000, so the company looks at the USD/GBP currency pair to see how many British pounds sterling it needs to allocate to this investment.
The exchange rate is currently GBP/USD = 0.89. $1 is therefore worth £0.89. At the present time, the company would have to pay £89,000 for the warehouse. However, if this investment is planned for a later date, the exchange rate may change by then, resulting in a different purchase sum - to the advantage or disadvantage of the company.
For example, if the US dollar rises against sterling to GBP/USD = 0.91, the company will have to pay £91,000 for the warehouse. If the US dollar falls to GBP/USD = 0.87 against sterling, the investment costs only £87,000.
The company must now carry out a risk assessment and has three options: It acquires the hall immediately at the current price of £89,000.
It accepts the risk and waits with its investment until the planned time and then has to pay either more or less than the planned £89,000. It secures the current exchange rate in the form of a hedging option, with base currency and quote currency frozen. The company then has to pay no more and no less than £89,000 whether the US dollar rises or falls in the future.